Pablo Conde asks advisers, issuers and index providers how important proprietary indices are in portfolio construction.
Structured products have battled with image problems over the years, one enduring accusation being that they are sold as standalone investments rather than bought in a portfolio context. We are curious about the extent to which product development based on underlyings, rather than payoff, and the adoption of the idea of an 'investment approach' to the industry has neutralised this criticism.
In addition to the increasing slicing and dicing of brand name indices into styles and sectors, many of the recently-introduced underlyings are proprietary indices developed by the investment banks. In some markets, such as the US, demand for proprietary indices is among the most significant market developments of the past couple of years. Providers say advisers are particularly enthusiastic users.
Proprietary indices were initially developed from static stock or index baskets that were optimised for beta, but have since evolved to cover a broad range of objectives, including the provision of access to alpha. Here, you would expect much of the intellectual effort to be directed at the internal portfolio - making sure the algorithm governing allocation to a universe of possible investments produces returns - rather than at how its addition affects, say, a long-only equity portfolio. As Barclays Capital's global head of quantitative indices and strategies, Laurence Black, puts it, "We work with [the index team] on index portfolio construction, optimal weighting techniques, and index implementation, utilising many techniques that hedge fund portfolio managers employ in a cost efficient manner."
But this focus on internal mechanics does not exclude external utility. Tom Livingstone, structured products director at New-York based advisory firm Halliday Financial, thinks proprietary investments could have a major role to play in balancing portfolios. "These [new] indices are being developed to embrace the rationale of portfolio construction," he says, "And these indices provide you with laser precision in mitigating some of the risk, while participating in strategies and asset classes that otherwise would be very difficult for retail clients to participate in."
For a long time these indices were fundamental research indices such as the DB Croci or the CS Holt, but then there was some innovation in this area, mainly because the options on those indices were quite expensive, and the banks started to sell outperformance options. Then the demand for long and short strategies increased and we saw indices like the DB alpha pairs, using fundamental strategies. Then several players started to focus on vol targeting and started to put together on the equity side strategic, quantitative algorithmic indices. On the hybrid side we also saw very successful indices such as the DB liquid alpha and GS dynamo. Soc Gen had an equivalent, Barcap has an equivalent - almost every i-bank now has an equivalent to those indices.
Livingstone is not alone. Christian Pemberton, executive director at Morgan Stanley, says the bank's research shows a growing number of retail investors are buying products based on custom indices to create an overlay in the portfolio that benefits from market downturns. Pemberton points out however that these strategies are not being marketed in the retail space as long daily variance short weekly variance but as a mean reversion strategy.
Although some of this allocation must be made on an intuitive basis, it can also be pinned on research, since many algorithmic indices are based on hedge fund styles whose returns are inherent to strategies such as trend following or statistical arbitrage. At this point, the work done on hedge fund returns and structured products underlyings overlaps. Hedge fund academics William Fung and David Hsieh, for example, have written a series of papers exploring the way hedge fund returns differ from those of traditional asset classes, assigning asset-based style factors to them so that the impact of various scenarios on the individual style and thus on a whole portfolio can be catered for.
Back in the structured products universe, Black takes more of a core/satellite approach to the underlying indices Barclays has developed. "It is our belief that the alpha performance can be split into idiosyncratic alpha and systematic alpha and we can capture systematic alpha through proprietary indices," he says. For example, the bank's Q-Series range has been designed as a cost-effective way of capturing 'systematic alpha'. "If I consider fundamental valuation techniques, diversification, non-correlation, all the way through from mean variance optimisation and high frequency trading like hedge funds, we try to incorporate many of these techniques and factors into our indices, which are part of the passive asset management space," he says.
Barclays' research teams are working on expanding its proprietary beta range, which complements the alpha products with various equity returns. "We are opening the industry to all sorts of investors by capturing those factors without having to go to a mutual fund or hedge fund to access a similar strategy," he says. The selling point for the products is that they are efficient (as well as cost-effective), because their rules-based nature prohibits style drift.
However, not all broker dealers and advisers are prepared to be generous about banking motivations: "Proprietary indices are a response from providers to the difficulties of structuring using mainstream equity benchmarks... If conditions improve I don't think they will have such a high profile in the marketplace," says Scott Miller Jr, a managing director at Pennsylvania-based Blue Bell Private Wealth Management. "I don't think underlyings have changed to enable structured products to be placed in the wider investment portfolio."
This is not a kneejerk, says Miller, who has compared the potential return he can get with a strategy-based underlying and the potential return of listed options. "The pricing on listed options is as good as the pricing offered by structured products linked to these proprietary indices," he says. He currently favours writing covered calls against ETFs, which he says provides better liquidity without credit risk. He finds this works well in conjunction with structured products on more regular underlyings, which provide payoffs it would be difficult for him to replicate himself. "Using listed options has become more attractive than a couple of years ago. As the ETF markets have grown, so too has efficiency in the option trading," he says.
Rubber on the road
It is not always the purported performance characteristics that holds clients back so much as their actual track record, or lack of it. As Halliday's Livingstone so clearly puts it, "Some of these structures around proprietary indices are going to be very successful - we just don't know which ones."
"Where the rubber hits the road here is that you develop a structure around an index and you let the structured product go for its full life, and then you have to compare that performance with what you said the performance was going to be. Clients do not want to be the pigeon that tests these things."
Thus, while Livingstone theoretically adheres to the idea of using algorithmic indices, his clients are unhappy with either the amount of or reliance on back-testing. In practice, therefore, "We will not do this type of index-linked strategy until we're comfortable with that back testing." Blue Bell's Miller agrees. At close inspection, the historical performance for many products seems to be data-mined and over-optimised to show positive past performance, he says. "If you believe data mining was used as a sales tool then [the back-testing doesn't] have much value; if you believe in the back testing then it can be valuable... We found that if you don't understand how the index is calculated then it's difficult to justify including them in any portfolio."
And Morgan Stanley's Pemberton does not deny that 'some banks' over-optimise the back-testing, though he says most providers have implemented out-of-sample testing to ensure a strategy is legitimate. Equally, the majority of quantitative strategies are easily understood and transparent, and investors can get a spread sheet out and calculate how the strategy will change if the underlying prices change, he says.
Clients have clear priorities when ranking indices, he says: "The risk-adjusted performance; how well it prices; how much AUM it has - no one wants to be the guinea pig - and for how long has it been live," he says.
Barclays Capital is also very well positioned to address back-testing and performance issues, as it calculates more than 30,000 indices daily. There is somewhere in the region of £6tr in assets benchmarked against Barcap indices, primarily on the fixed income side, and around £100bn in real assets traded on them. Many are traded by retail investors, and many are available as ETFs. The 150 staff members looking after the indices sit in a separate compliance- controlled department where they are independently verified, says Black.
Portfolio construction
While many proprietary indices implement the same trading strategies as asset managers, the point of structured products is that they are combined with a derivatives strategy which alters the payoff in some way from the underlying strategy, often by adding capital protection. If we add this variety of possible payoffs to the potential complexity of the underlying, it no longer seems appropriate (if it ever did) to view them as an asset class in their own right. The idea of core holdings and 'alternatives' is almost hard wired in some quarters, though, and this is where structured products in general are often placed.
"Certainly by putting a limit you diversify your risk regardless of your level of knowledge about the product," says Steven Goldin, global head of strategy indices at S&P. "However... it doesn't address how these products will add value in a portfolio context beyond diversification. Understanding the product's objective in terms of growth, growth and income, or income products, and the likelihood of its achieving its objective are also important."
Halliday's Livingstone also thinks using percentages does not make any sense, but in practice none of his clients has a portfolio with more than 20-25% in structured products: "In general, we have found that it just doesn't fit," he explains. "You have to put some limits, but you have to differentiate structured products into different categories... We're inclined to be a bit more heavily weighted in [FDIC-backed] principal-protected products, depending on their duration...".
Blue Bell emphasises diversifying pay-off profiles, and staggering start dates and maturities. "Having investments starting at and coming due at different times akin to a bond ladder... increases the chance of us using the buffer protection that we like and decreases the negative of a maximum return. If we have a strategy coming due at one time it may cap out, but if we have a ladder some may cap out, but some may level returns up and some may take advantage of downside protection."
This in the end appears to be what matters. When products have gone full term, concludes Livingstone, "...There will be some winners and some absolute monstrous blunders. Those firms making business based on the premise of mitigating risk will be the most successful."
